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WHY THE “ACCREDITED INVESTOR” STANDARD
FAILS THE AVERAGE INVESTOR
SO-YEON LEE*
I.
Introduction
“The rich get richer” is a timeless truth.1 While this may be
self-evident, some of the reasons why the rich seem to get richer are
less apparent. Surprisingly, U.S. securities regulations award special
investment privileges to the already affluent, resulting in a legal
system that makes it even easier for them to amass wealth.2
Private placements operate as one such privilege. Because
most investment decisions are executed in a public marketplace, rules
that govern securities market transactions can directly impact an
investor’s earning capacity.3 By placing limitations on who can
invest in private placements, regulators seek to protect investors and
the amount of risk they can undertake.4 Risk and return, however, are
incontrovertibly linked: if one investor is able to take advantage of
investment opportunities that are unavailable to others, he or she may
potentially earn larger returns.5 Consequently, the government’s
* Boston University School of Law (J.D. 2012); University of Nevada, Las
Vegas, Finance (B.S.B.A. 2009). Ms. Lee thanks Professor Tung for his
insightful review of an earlier draft, as well as the staff and editors of the
Review of Banking and Financial Law for their help in preparing this note
for publication, with a special thanks to Executive Editor for Notes &
Comments, Mirela Hristova, for her meticulous and thoughtful edits.
1
See Robert C. Lieberman, Why the Rich Are Getting Richer, FOREIGN
AFFAIRS, Jan. 2011, http://www.foreignaffairs.com/articles/67046/robert-clieberman/why-the-rich-are-getting-richer?page=2.
2
See id.
3
Robert J. Bloomfield, The “Incomplete Revelation Hypothesis” and
Financial Reporting, 16 ACCT. HORIZONS 233, 239 (2002).
4
See Jerry W. Markham, Protecting the Institutional Investor—Jungle
Predator or Shorn Lamb?, 12 YALE J. ON REG. 345, 354 (1995). Access to
better investment opportunities is just one why of explaining why a
particular investor is more profitable than another. Access to better
information is an important factor as well. Nonetheless, this note limits its
focus to investment opportunities.
5
Balancing Risk and Return to Meet Your Goals, OFFICE OF THE ATTORNEY
GEN. OF THE STATE OF N.Y., http://www.oag.state.ny.us/investorprotection/balancing-risk-and-return-to-meet-your-goals (last visited Apr. 5,
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placement of regulatory limits on an investor’s potential risks also
limits that investor’s potential returns.6
While there are many regulations currently in place that deal
with risk, this note focuses on the private placement exemption and
how it affords wealthier investors better investment opportunities
than those available to retail investors. Part II of this note discusses
the specifics of private placements and explains why the current
“accredited investor” standard is ineffective. Part III expounds on the
current status of retail investors and their investment opportunities.
Part IV argues that retail investors should be allowed to invest in
private offerings.7 Part V concludes with a recommendation.
II.
Private Placements and Why the Current “Accredited
Investor” Standard is Ineffective
Under the Securities Act of 1933 (“1933 Act”), issuers
seeking public financing must either register their securities with the
Securities Exchange Commission (“SEC”) or meet an exemption to
registration.8 Private placements are an exception to that general rule,
as the government exempts transactions by issuers that do not
involve public offerings.9 Generally, the primary private placement
market deals in transactions that involve a limited number of
sophisticated investors buying a new issue of non-public securities
that are exempt from registration.10 Regulation D—promulgated by
the SEC in order to institute safe harbors for issuers of private
placements—affords issuers one of the main ways to qualify for
exemptions.11 This note will limit its discussion to the “accredited
2012). If one investor is allowed to invest in a security that will yield a 10
percent return while another one can only invest in a security that will yield
a 5 percent return over the same time period, then the latter investor will
generate lower returns than the first investor.
6
See example in supra note 5.
7
This note recognizes that retail investors may indirectly invest in private
offerings by investing through institutional investor such as mutual funds,
but characterizes these types of transactions as institutional investor
transactions.
8
Securities Act of 1933, 15 U.S.C. § 77c (West 2006).
9
Id.
10
MELANIE L. FEIN, SECURITIES OF ACTIVITIES BANKS § 10.01 (4th ed.
2011).
11
Markham, supra note 4, at 354–55.
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investor” standard used in Regulation D offerings, which are
responsible for many registration exemptions today.
A.
Regulation D Offerings
Regulation D exemptions are private placements that allow
issuers to issue securities to private investors without undergoing a
cumbersome registration process designed to protect unsophisticated
investors.12 Through the use of private placements, an issuer may
reduce its cost of issuances by avoiding the traditional registration
process with the SEC for public issuances.13 Regulation D sets forth
substantive and procedural rules, which operate to exempt certain
transactions from registration.14 More specifically, Rules 505 and
506 provide registration exemptions to issuers issuing securities to
“accredited investors” and up to thirty-five non-accredited
investors.15
1.
Who Can Invest in Regulation D
Offerings?
Historically, only “sophisticated investors,” those who were
able to “fend for themselves,” could invest in private placements.16
Later, the SEC developed an “accredited investor” standard for
Regulation D offerings, which uses quantifiable metrics to create
bright-line rules for determining whether investors are capable of
fending for themselves.17
As defined, accredited investors include: financial
institutions, pension plans, venture capital funds, corporations and
other organizations exceeding a certain size, insider of the issuer,
12
Id.
Id.
14
John V. Bautista, Key Considerations in Forming a New Company, in
VENTURE CAPITAL 2012: NUTS AND BOLTS 87, 111–18 (Corporate Law &
Practice Course Handbook Ser. No. 34817, 2012).
15
Id.
16
SEC v. Ralston Purina Co., 346 U.S. 119, 125 (1953).
17
Accredited Investors, SEC.GOV, http://www.sec.gov/answers/accred.htm
(last visited Apr. 5, 2012).
13
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natural persons with wealth or income exceeding certain threshold
amounts and entities owned by accredited investors.18
Natural persons seeking to qualify as accredited investors
must meet either net worth qualifications or income qualifications.19
To meet net worth qualifications, a natural person’s net worth must
exceed $1 million, either individually or jointly with the individual’s
spouse.20 Alternatively, a natural person must have “income
exceeding $200,000 in each of the two most recent years or joint
income with a spouse exceeding $300,000 for those years and a
reasonable expectation of the same income level in the current
year.”21
The reasoning behind allowing accredited investors to invest
freely in Regulation D private placements is that they are deemed to
possess the requisite sophistication and resources to obtain disclosure
from issuers and evaluate the risks of private offerings on their
own.22
2.
Are Accredited Investors Necessarily
More Sophisticated?
Recent criticisms of the private placement exemption focus
heavily on the idea that wealthy individual accredited investors
should receive full protection under U.S. securities regulations
because they are not necessarily capable of fending for themselves.23
The dominant narrative offered as an explanation for the Great
Recession of 2008—that investors took risks that they did not
understand and that they were inadequately compensated for these
18
JAMES D. COX, ROBERT W. HILLMAN & DONALD C. LANGEVOORT,
SECURITIES REGULATION: CASES AND MATERIALS 283–85 (6th ed. 2009).
19
Id. at 284–85.
20
17 C.F.R. § 230.501(a)(5). Section 413(a) of the Dodd-Frank Wall Street
Reform and Consumer Protection Act directs the SEC to “adjust the net
worth standard for an accredited investor . . . so that the individual net worth
of any natural person, at the time of purchase, is more than $1,000,000 . . . ,
excluding the value of the primary residence of such natural person . . . .”
Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010,
Pub. L. No. 111-203, § 413(a), 124 Stat. 1376, 1577 (2010).
21
17 C.F.R. § 230.501(a)(6).
22
Jennifer J. Johnson, Private Placements: A Regulatory Black Hole, 35
DEL. J. CORP. L. 151, 153 (2010).
23
Id. at 155.
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risks—supports this view as well.24 As a result, many have advanced
arguments for a reformation of our financial laws and regulations in
favor of increased regulatory oversight.25
An individual investor’s level of wealth does not necessarily
share a positive correlation with his or her investment expertise
because wealth may be obtained in a number of ways that require no
investment knowledge, for instance by inheritance.26 Thus, investors
meeting the monetary qualifications set forth in the definition of
accredited investor are not necessarily more sophisticated than retail
investors.27 At least for natural persons, having a certain net worth or
a certain level of income does not imply an ability to obtain and
evaluate issuer disclosures related to a particular security.28
The justification behind allowing wealthy and potentially
unsophisticated investors who can afford to lose money to invest in
mispriced securities is that this exception encourages capital
formation.29 By using private placements to issue securities to
accredited investors, issuers are able to make efficient use of capital
to build their businesses.30 This is partly due to the fact that issuing
private placements reduces the transaction cost involved in obtaining
money from capital markets since the issuers can avoid costly
regulation.31
On the other hand, by defining accredited investors as
individuals who meet certain net worth or income requirements, U.S.
securities regulations limit the potential pool of investors in private
placements to individuals who are deemed wealthy enough to take on
24
Andrey D. Pavlov & Susan M. Wachter, Systemic Risk and Market
Institutions, 26 YALE J. ON REG. 445, 452 (2009).
25
See generally Johnson, supra note 22 (questioning the wisdom of leaving
private placements unregulated and urging a return of the power to regulate
such offerings to the states).
26
See Paul Sullivan, Managing and Investment Portfolio of Risks, Not Only
Returns, N.Y. TIMES, Aug. 5, 2011, http://www.nytimes.com/2011/
08/06/your-money/asset-allocation/managing-risk-in-an-investmentportfolio-wealth-matters.html?ref=investments.
27
See COX, HILLMAN & LANGEVOORT, supra note 18, at 283–85.
28
Id. at 258 n.1.
29
Howard M. Friedman, On Being Rich, Accredited, and Undiversified: The
Lacunae in Contemporary Securities Regulation, 47 OKLA. L. REV. 291,
299–300 (1994).
30
Id. at 300.
31
See infra Part IV
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higher levels of investment risk than non-accredited investors.32
Consequently, the current securities regulations balance the need for
efficient capital formation against the desire to limit risks undertaken
by investors.33
In sum, accredited investors are not necessarily more
sophisticated than non-accredited investors; however, accredited
investors are allowed to take higher amounts of investment risk in
favor of efficient capital formation.34
B.
Why the Current “Accredited Investor”
Standard is Less Effective
In light of the above, neither net worth nor adjusted gross
income are necessarily good indicators of whether a certain
individual is better suited to take bigger investment risks and to
absorb financial losses than another individual with a lower net
worth or lower income level.
Net worth is the sum of all of an individual’s liquid and nonliquid assets minus liabilities.35 Assets can be broken up into three
parts: large assets, personal items and assets that are liquid.36
Examples of large assets include real property and cars.37 Personal
items, on the other hand, can consist of items like jewelry, stamp
collections and musical instruments.38 Finally, liquid assets include
items such as cash on hand, cash in checking or savings accounts,
stocks, retirement funds and other investments.39 The sum of an
individual’s liquid and non-liquid assets equals his or her total asset
value.40 Similarly, to calculate an individual’s total liabilities, all of
his or her liabilities must be totaled, including mortgages, car loans,
32
See id.
See id.
34
See id.
35
See Net Worth Methods of Proof, I.R.M. 9.5.9.5.8.1 (2012), available at
http://www.irs.gov/irm/part9/irm_09-005-009.html#d0e678 (listing nonexclusive factors to be considered in determining adjustments in net worth);
Jeremy Vohwinkle, How to Calculate Your Net Worth, http://
financialplan.about.com/od/personalfinance/ht/networthhowto.htm
(last
visited Apr. 5, 2012) (explaining how financial wealth is calculated).
36
Vohwinkle, supra note 35.
37
Id.
38
Id.
39
Id.
40
Id.
33
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student loans and credit cards.41 Therefore, the net worth standard
simply measures an individual’s total assets minus total liabilities,
without regard for whether the assets are liquid or non-liquid.42
Whether assets are liquid or non-liquid matters because nonliquid assets are more difficult to convert to cash than liquid assets.43
Therefore, high net worth investors who have insufficient liquid
assets may be forced to liquefy their assets for cash. 44 For example,
if an investor uses liquid assets to make an investment and that
investment fails to deliver expected returns to the investor, then that
investor may have to liquefy non-liquid assets to meet his or her
ongoing need for capital.45 When the investor decides to convert a
non-liquid asset to cash, he or she faces liquidity risk—i.e., having to
sell the non-liquid asset at a significant discount in order to sell the
asset quickly.46
The adjusted gross income standard is also ineffective in
determining whether a particular investor is in a position to absorb
financial losses.47 Because adjusted gross income fails to consider the
full extent of an individual’s expenses, an investor may have
sufficient adjusted gross income, but may not have the requisite
funds to absorb financial losses.48 For example, an individual who
earns $200,000 annually may have annual liabilities that exceed this
amount.49 An individual with less adjusted gross income who has
proportionately lower liabilities is better positioned to absorb
financial losses.50
Instead, the accredited investor standard should consider
whether an investor has the requisite discretionary income to risk in
making investments. Discretionary income is commonly defined as
an individual’s adjusted gross income minus taxes and necessities
such mortgage, utilities and food cost, and should reflect the portion
of his or her income that can be used for spending or saving.51 For
41
Id.
Id.
43
See 69 AM. JUR. 2D Securities Regulation—Federal § 738 (2008).
44
See id.
45
See id.
46
REAL ESTATE INVESTOR'S DESKBOOK § 2:93 (3d ed. 1994)
47
See 26 U.S.C. § 62 (2010) (defining adjusted gross income).
48
See id.
49
See id.
50
See supra text accompanying notes 35–42.
51
See Alan L. Feld, Fairness in Rate Cuts in the Individual Income Tax 68
CORNELL L. REV. 429, 448–49 (1983).
42
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example, if an individual has an adjusted gross income of $100, is
taxed $25, and has rent, food, transportation and other living
expenses that total $60, then he or she has discretionary income of
$15. In light of this, an investor can afford to absorb losses equal to
the amount of discretionary income he or she has available.52 In this
scenario, issuers may voluntarily determine that it is not worth it for
the organization to transact with an individual who only has a few
dollars of discretionary income; however, the government has no
reason to bar such financial transactions. If the issuer and the investor
both elect to participate in the transaction and the individual has the
capacity to absorb potential financial loses stemming from the
investment, then that investor should be allowed to take that risk and
reap the potential benefits of the investment. This may lead to better
capital formation by allowing issuers to borrow from a larger pool of
investors.
Since net worth standards include both the liquid and illiquid
assets of a particular investor while income standards factor in his or
her adjusted gross income, an investor who meets the accredited
investor standard may have less discretionary income than another
one who does not. For example, if A is retired and has a net worth of
$1 million, but the vast majority of A’s net worth is invested in real
properties—none of which A uses as a primary residence—A
qualifies as an accredited investor. Or, if A is single, lives in New
York City53 with an annual income of $200,000 and has four
children, A qualifies as an accredited investor. On the other hand, if
B is single, lives in Harlingen, Texas54 with an annual income of
$195,000 and has no children, B does not qualify as an accredited
investor.55 Although in each example, A is an accredited investor and
B is not, B is likely to have more discretionary income than A.
Furthermore, even if B only has discretionary income of $50, B
should be able to invest this money as he or she pleases without
unnecessary limitation.
The discretionary income standard is a better financial
measure of determining whether a particular investor can afford to
52
See id.
New York City has the highest cost of living in the country. Joe Light,
The Most and Least Expensive Cities, WALL ST. J., Oct. 28, 2011,
http://blogs.wsj.com/totalreturn/2011/10/28/the-most-and-least-expensivecities/.
54
Harlingen, Texas has the lowest cost of living in the country. Id.
55
See COX, HILLMAN & LANGEVOORT, supra note 18, at 283–85.
53
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make risky investments because it quantifies his or her capacity to
absorb financial losses.56 Moreover, by limiting a particular
investor’s total investment in private placements to the precise dollar
amount of that individual’s discretionary income, regulators can
insure that investors who do invest in private placements can truly
bear the risks of their investments. Applying a discretionary income
standard in determining whether a particular investor qualifies as an
accredited investor may result in better access to capital for issuers
seeking investors and increase investment opportunities for retail
investors.57
III.
The Current Status of Retail Investors and Their
Investment Opportunities
The percentage of institutional investors relative to retail
investors in the U.S. trading market is growing, which has potential
advantages and disadvantages.58
Since the 1950s, the proportion of institutional investors to
retail investors in the U.S. financial markets has changed, and the
percentage of retail investors’ direct ownership of securities has
decreased dramatically.59 First, institutional investors’ percentage
ownership of publicly-traded securities, as well as of privately-placed
securities, has increased steadily since the 1950s.60 For instance,
institutional investors held 26 percent of outstanding stock in 1956,
and almost 40 percent by 1970.61 When the SEC adopted Regulation
D in the 1980s,62 the percentage of New York Stock Exchange-traded
56
See Friedman, supra note 29, at 299.
This note does not compare the administrability of the discretionary
income standard to that of the current accredited investor standard. If the
discretionary standard is significantly more costly or difficult to implement,
then it may not be the best solution. The author encourages future papers to
explore the administrability of a discretionary income standard as compared
to the existing accredited investor standard.
58
See Markham, supra note 4, at 347–49.
59
See id.
60
Id.
61
Id.
62
See EDWARD F. GREENE ET AL., 1 U.S. REGULATION OF THE
INTERNATIONAL SECURITIES AND DERIVATIVES MARKETS: UNITED STATES
REGULATION OF THE INTERNATIONAL SECURITIES AND DERIVATIVES
MARKETS 5 n.9 (2005).
57
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stock held by institutional investors was approximately 35 percent.63
By 1990, institutional investors held 39 percent of all over-thecounter stocks and 87 percent of all privately-placed securities.64
Second, there has been a reciprocal drop in the percentage of direct
ownership of publicly-traded securities by retail investors.65 Retail
investors’ ownership decreased from approximately 84 percent of
outstanding securities in 1965 to approximately 53 percent in 1991.66
Table 1: Proportion of Market Ownership by Institutional
Investors67
Publicly-traded
equities ($21.5
trillion)
Publicly-traded debt ($10.7
trillion)
Mutual funds
Public pension
funds
Private pension
funds
Life Insurance
companies
28.9%
10.0%
13.4%
2.4%
12.9%
2.9%
8.0%
20.3%
Financial
Institutions
Endowment
funds
Foreign
Investment
Retail
(individuals)
1.4%
14.8%
13.0%
23.3%
25.4%
15.2%
63
Joel Seligman, The Future of the National Market System, 10 J. CORP. L.
79, 114 (1984).
64
Markham, supra note 4, at 347–49.
65
See id.
66
Id.
67
Alan Palmiter, Staying Public: Institutional Investors in U.S. Capital
Markets, 3 BROOK. J. CORP. FIN. & COM. L. 245, 261 (2009) (emphasis
added).
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Today, retail investors directly own approximately 25
percent of publicly-traded equities and approximately 15 percent of
publicly-traded debt, while institutional investors own approximately
75 percent and 85 percent, respectively.68 Additionally,
approximately 90 percent of all private placements are made to
institutional investors.69 Historical trends show that retail investors
are quickly moving away from direct ownership of securities.70 If this
trend continues, retail investors’ direct ownership of securities may
eventually dwindle down to negligible proportions.71
If retail investors are disappearing from the trading market,
how would an all-institutional investor trading market impact the
U.S. financial markets at large? The possible benefits and drawbacks
are examined below. Ultimately, this note advances the idea that,
based on the prevailing economic theory of supply and demand, the
absence of retail investors will likely result in an increase in the cost
of obtaining capital from the public.
A.
Potential Advantages of the
Proportion of Retail Investors
Shift
in
the
Some commentators argue that an all-institutional investor
trading market will result in several benefits such as increased market
efficiency, better corporate governance and decreased need for
securities regulation.72
1.
Market-Efficiency
Commentators argue that an all-institutional investor market
would be more efficient than a market that includes retail investors.73
Many consider retail investors to be “‘noise traders’ that distort share
prices and harm market functioning.”74 Pursuant to this argument, in
the absence of “noise traders,” the market would be more effective at
68
Id.
See Markham, supra note 4, at 347–49.
70
See supra text accompanying note 66.
71
See Markham, supra note 4, at 347–49.
72
Alicia Evans, A Requiem for the Retail Investor?, 95 VA. L. REV. 1105,
1115–27 (2009).
73
Id. at 1116.
74
Id. at 1118.
69
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setting prices because prices would be based on issuer disclosures
and not fads or other types of unreliable information.75
Based upon this theory, retail investors harm market
efficiency because they make irrational trade decisions that are not
grounded in valid information.76 This theory thus predicts that a
market without retail investors would become more efficient.77
2.
Better Corporate Governance
The second argument in favor of an all-institutional investor
market is that such a market would ensure better corporate
governance.78 The reasoning behind this argument is that institutional
investors have greater ability to monitor issuer corporations because
they are sophisticated market actors and have greater bargaining
power.79 Because institutional investors are more sophisticated, an
institutional investor-driven market can effectively price various
forms of issuer disclosure by demanding them from the issuers.80
Furthermore, institutional investors possess the means to better
monitor issuer corporations to ensure compliance with regulatory
standards for issuer disclosures in connection with an issuance.81
Underlying this argument are the assumptions that markets
are efficient and that institutional investors have an incentive to
monitor issuers.82 Critics, however, have pointed out that institutional
investors have failed to monitor issuers in the past and that there is
no reason to assume that an all-institutional investor market will
promote better corporate governance.83
75
See id. at 1118 n. 49.
See id.
77
Id. at 1115–19.
78
Id. at 1122–25. See generally Donald C. Langevoort, The SEC, Retail
Investors, and the Institutionalization of the Securities Markets, 95 VA. L.
REV. 1025 (2009) (exploring the idea that an “anti-fraud only” regulatory
scheme would emerge from an all-institutional investor trading market and
arguing that institutional investors could demand proper issuer disclosures
in such a market).
79
See id.
80
Evans, supra note 72, at 1122.
81
Id. at 1124–25.
82
Id.
83
Id. at 1123.
76
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999
Decreased Need for Securities Regulation
The third argument in favor of an all-institutional investor
market is that such a market would not require as much regulation.84
Because an all-institutional investor market could demand and
properly price needed issuer disclosures, it would not require as
much regulatory protection.85 This is because institutional investors
are deemed to be sophisticated and able to fend for themselves,
which means that they are able to determine which disclosures are
necessary to make informed investment decisions.86
Furthermore, institutional investors would be better suited to
absorb losses from issuer wrongdoing—such as issuer fraud—
because they are more likely to hold diversified investments.87 Stated
differently, unlike undiversified investors, institutional investors
have other investments to spread the losses over.
From the corporate issuer’s perspective, the benefit of less
regulation is that market actors will have fewer regulations to comply
with, which will in turn reduce the costs of regulatory compliance.88
Overall, this may lead to more efficient capital formation and access
to cheaper capital for issuers that are able to offer more attractive
rates for private placements to institutional investors.
B.
Potential Disadvantages of the Shift in Proportion
of Retail Investors
While there are potential advantages of an institutional
investor driven trading market, there are also arguments for potential
disadvantages such as increased cost of obtaining capital, decreased
market efficiency and a decline in the quality of corporate
governance.
84
Id. at 1125.
See id. at 1122–25.
86
See supra text accompanying note 16.
87
Evans, supra note 72, at 1125–27.
88
See id.
85
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Increased Costs of Obtaining Capital
In an all-institutional investor market, the cost of obtaining
capital from financial markets would likely rise. If an issuer’s supply
of investment capital is channeled entirely through institutional
investors, then issuers will have to obtain capital from a limited
supply of investors.89
As with any supply and demand curve, if the supply of
investors decreases and the demand for investors remains the same,
then the supply curve must shift so that the cost of obtaining capital
from investors would increase and the quantity of investors would
decrease. If a decrease in the number of investors leads to issuers
paying a higher cost for capital, then issuers’ total costs of
production will also rise because the cost of obtaining financing is a
factor in determining the total cost of production.90
Conversely, in a market where retail investors participate in
trades, issuers have access to a larger pool of investors, resulting in a
lower cost of obtaining capital from the financial market. It logically
follows that if a larger number of retail investors were to participate
in trades, then the supply of investors would increase, shifting the
supply curve and lowering the cost of obtaining capital from the
financial markets.91
2.
Decreased Market Efficiency
A minority of commentators argues that retail investors can
bring “relevant private information” to the market, which helps set
market prices and therefore increases market efficiency.92 Some
additionally argue that retail investors contribute to the marketplace
by increasing market liquidity.93 An efficient market requires
liquidity.94 By providing additional liquidity, retail investors
therefore increase market efficiency.95 Conversely, the exclusion of
89
See id. at 1122.
See Production and Costs: The Theory of the Firm, STATE UNIV. OF N.Y.
OSWEGO, http://www.oswego.edu/~atri/production.html (last visited Apr. 2,
2012).
91
See id.
92
Evans, supra note 72, at 1119.
93
Id.
94
Id.
95
See id.
90
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retail investors should result in decreased market liquidity and a less
efficient market.96
Because institutional investors often execute large trades,
there are also concerns that liquidity would be in short supply in an
all-institutional investor market.97 Institutional investors may
experience difficulty in finding counterparties for large trades.98 As a
result, they are sometimes forced to “[lower] their ask price or [raise]
their bid price in order to attract interest from other investors.”99
Because of the higher liquidity costs associated with executing large
volume trades, institutional investors may create market noise that
results in the mispricing of securities and a less efficient market.100
3.
Decline in the Quality of Corporate
Governance
Critics argue that a reduction in retail investor participation
in the trading market would lead to a correlating decline in the
quality of corporate governance.101 Historically, institutional
investors have been passive investors.102 Institutional investors are
primarily interested in “provid[ing] retail investors with the benefits
of a diversified portfolio, not . . . act[ing] on their own behalf as
independent players in the financial markets[,]” remaining “largely
irrelevant for corporate governance purposes.”103 Consequently,
institutional investors may not have a vested interest in actively
monitoring corporate governance issues.104
In contrast, retail investors do put their own money on the
line in making investments, and have incentive to take action to
96
See id.
See Stavros Gadinis, Market Structure for Institutional Investors:
Comparing The U.S. and E.U. Regimes, 3 VA. L. & BUS. REV. 311, 315
(2008).
98
Id.
99
Id.
100
Id.
101
See Evans, supra note 72, at 1122–25.
102
Robert C. Illig, What Hedge Funds Can Teach Corporate America: A
Roadmap For Achieving Institutional Investor Oversight, 57 AM. U. L. REV.
225, 237 (2007).
103
Id.
104
Id.
97
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REVIEW OF BANKING & FINANCIAL LAW
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enhance corporate governance.105 Therefore, based on historical
evidence, an all-institutional investor market is likely to result in
worse corporate governance.106
C.
Consequences of the Decline in the Number of
Real Investors
There are valid arguments on both sides of the debate as to
the effect that the decline in the number of retail investors would
have on market efficiency and corporate governance.107 Both sides’
arguments have merit; however, if one takes seriously the
proposition that the absence of retail investors is associated with an
increased cost of obtaining capital for issuers, this could also
negatively affect market efficiency.
If the cost of obtaining capital for issuers rises, financial
markets will probably become less efficient because market
efficiency depends largely upon trading volume.108 If trading volume
decreases, then, market efficiency is also expected to decrease.109
Trading volume is likely to decrease in a market where the cost of
obtaining capital is higher because the higher cost of obtaining
capital will increase the cost of trading transactions.110 In an allinstitutional investor trading market, transaction costs are likely to
increase for two main reasons: first, there will be fewer investors
executing small trades providing liquidity;111 second, the price of
securities may become less stable as a result of institutional investors
executing large trades.112
105
See Jennifer S. Taub, Able But Not Willing: The Failure of Mutual Fund
Advisers To Advocate For Shareholders, 34 J. CORP. L. 843, 844 (2009).
106
See Evans, supra note 72, at 1122–25.
107
See id.
108
See id.
109
See id.
110
See Gadinis, supra note 97, at 315.
111
See id.
112
See id.
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IV.
“ACCREDITED INVESTOR” STANDARD
1003
Why Retail Investors Should Be Allowed to Invest in
Private Placements
In 2011, 54 percent of Americans had invested in the stock
market.113 Nonetheless, the vast majority of Americans are precluded
from investing in private placements because they do not meet the
income standard or the net worth standard.114
A.
Who is the Average American Retail Investor?
The vast majority of American households have an average
income below the threshold amount of $200,000 necessary to meet
the accredited investor standard.115 Although the average income has
steadily increased over the years from approximately $4,000 per year
in 1960 to over $40,000 per year today, most Americans fall far short
of the requisite $200,000 per year.116 Indeed, in 2010, the average
American household was composed of 2.58 members,117 and had an
annual income of approximately $42,000.118 As few as 5 percent of
American households have sufficient income to qualify as accredited
investors under the income standard.119
113
Dennis Jacobe, In U.S., 54% Have Stock Market Investments, Lowest
Since 1999, GALLUP ECON., Apr. 20, 2011, http://www.gallup.com/
poll/147206/stock-market-investments-lowest-1999.aspx (graphing the
percentage of Americans invested in the stock market from 1999 through
2011).
114
See infra text accompanying note 119 (describing the percentage of
Americans who meet the income standard or the net worth standard to be
eligible to invest in private placements).
115
See U.S. CENSUS BUREAU, STATISTICAL ABSTRACT OF THE UNITED
STATES: 2012, at 455 (2012) [hereinafter STATISTICAL ABSTRACT].
116
National Average Wage Index, SSA.GOV, http://www.ssa.gov/oact/
COLA/AWI.html (last visited Apr. 5, 2012).
117
Census Bureau Releases 2010 Census Demographic Profiles for the
United States, Arkansas, Illinois, Indiana, Iowa, Louisiana, Maryland, New
Jersey, Oklahoma, Oregon, South Dakota, Texas, Vermont and Virginia,
U.S. CENSUS BUREAU (May 26, 2011), http://www.census.gov/
newsroom/releases/archives/2010_census/cb11-cn144.html.
118
National Average Wage Index, supra note 116.
119
See STATISTICAL ABSTRACT, supra note 115, at 469.
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Graph 1: U.S. Income Distribution120
50.00%
40.00%
$0-$49,999
30.00%
$50,000-$99,999
20.00%
$100,000$149,999
10.00%
0.00%
Income (in Dollars)
$150,000$199,999
Graph 2: Average Wages of Americans121
$45,000.00
$40,000.00
$35,000.00
$30,000.00
$25,000.00
$20,000.00
$15,000.00
$10,000.00
$5,000.00
$0.00
1960
1970
1980
1990
2000
2010
Average Salary
Moreover, most Americans do not meet the net worth
standard.122 The age group with the highest net worth is Americans
between the ages of sixty-five to seventy-four,123 and this is also the
only group of American adults whose average net worth either meets
120
See id.
See National Average Wage Index, supra note 116.
122
See STATISTICAL ABSTRACT, supra note 115, at 469.
123
Id.
121
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“ACCREDITED INVESTOR” STANDARD
1005
or exceeds $1,000,000.124 Despite this average, the median income
within that age group is just $239,400.125 In addition, the U.S.
population between the ages of sixty-five and seventy-four only
makes up approximately 8.9 percent of the total population.126 Thus,
at most a fraction of 8.9 percent of the U.S. population is eligible to
invest in private placements based on their net worth.127
As a result, most American investors are unlikely to ever
qualify to invest in private placements unless they do so indirectly
through institutional investors. Furthermore, some percentage of
those who qualify based on their net worth may overlap with some
percentage of those who qualify based on their annual income.
Graph 3: Average Net Worth of Americans128
1,200,000
1,000,000
800,000
600,000
400,000
Mean
200,000
Median
0
Under 35 to 45 to 55 to 65 to
75
35
44
54
64
74 years
years years years years years old and
old
old
old
old
old
over
B.
Issuers Prefer Private Placements
Many issuers prefer to raise capital in the private placement
market because it is cheaper than raising money through public
124
Id.
Id.
126
See id., at 55.
127
See id.
128
See id. at 469.
125
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REVIEW OF BANKING & FINANCIAL LAW
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issuances.129 In addition, private placements allow issuers to
“preserve confidentiality, avoid the necessity of obtaining a rating,
issue securities with complicated or unusual terms, avoid delays
associated with registration, and delay take-down of funds.”130
Because of the many advantages associated with raising capital in the
private placement market, issuers have increasingly turned to private
placements to raise capital, creating a larger private placement
market.131 “As of 2006, the dollar amount of unregistered equity
shares sold through private placements in the U.S.—$162 billion—
exceeded the $154 billion raised in public offerings on U.S.
exchanges.”132
For smaller issuances, the cost of registering securities with the
SEC for a public offering is often at least twice the cost of certain
types of private offerings.133 In addition to the cost of registering
securities with the SEC, public company issuers must shoulder the
costs of complying with the Sarbanes Oxley Act of 2002 and its
disclosure, reporting and corporate governance requirements.134
Thus, the decision makers of some privately-owned companies might
prefer to raise capital through private rather than public offerings.135
Consequently, if it is more expensive for issuers to raise
money through a public offering than a private offering, then issuers
may be able to offer investors better terms for private issuances by
theoretically passing on the savings from avoiding securities
registration costs.
129
FEIN, supra note 10, § 10.01.
Id.
131
See id.
132
Id.
133
J. WILLIAM HICKS, 7 EXEMPTED TRANSACTIONS UNDER SECURITIES ACT
1933 § 6:130 (2007) (comparing the costs of Regulation A offerings to
public offerings).
134
“The purpose of the Sarbanes-Oxley Act, ‘as reported by Congress,
[wa]s ‘to address the systemic and structural weaknesses affecting our
capital markets which were revealed by repeated failures of audit
effectiveness and corporate financial and broker-dealer responsibility.’”
Ginger Carroll, Thanking Small: Adjusting Regulatory Burdens Incurred By
Small Public Companies Seeking to Comply With the Sarbanes-Oxley Act,
58 ALA. L. REV. 443, 443–44 (2006).
135
Id.
130
2011-2012
C.
“ACCREDITED INVESTOR” STANDARD
1007
The Effects of Special Investment Privileges
Currently, over 90 percent of private placements are placed
with institutional investors.136 When the SEC set forth a definition for
accredited investors in 1982, institutional investors made up a much
smaller percentage of overall investors—roughly 35 percent.137
Because institutional investors account for a majority of transactions
in the market, the private placement exemption operates to exclude
retail investors from taking advantage of investment opportunities
available in most transactions that take place today.
One of the reasons why institutional investors currently
dominate the market may be because in the past few decades,
institutional investors—such as mutual funds—had a regulatory
advantage: the 1933 Act “allows issuers, in certain limited
circumstances, to issue securities that will be traded only among
qualified institutional buyers without having to fully register the
securities.” 138 Thus, because issuers could avoid the full costs of
securities registration, they were able to raise capital through mutual
funds or other similar institutions more cheaply than through the
public market.139
Furthermore, according to a study of firms that issue bonds,
firms that switch between private issuances and public issuances are
larger and tend to have higher credit ratings than firms that only
borrow from the public.140 A larger company with a higher credit
rating is likely more stable and thus a more reliable investment than a
smaller company with a lower credit rating.141 As a result, companies
that issue both private and public securities are expected to constitute
more reliable investments for all investors.142
136
See Markham, supra note 4, at 347–49.
Id.
138
Shimon B. Edelstein, Indexing Capital Gains for Inflation: The Impacts
of Recent Inflation Trends, Mutual Fund Financial Intermediation, and
Information Technology, 65 BROOK. L. REV. 783, 811 (1999).
139
Id.
140
Simon H. Kwan & Willard T. Carleton, Financial Contracting and the
Choice Between Private Placement and Publicly Offered Bonds (Fed.
Reserve Bank of San Francisco, Working Paper No. 2004-20), available at
http://www.frbsf.org/publications/economics/papers/2004/wp04-20bk.pdf.
141
See Ethiopis Tafara, Global Capital Markets and the U.S. Securities
Laws 2009: Strategies for the Changing Regulatory Environment, 1743 PLI/
CORP. 1111, 1123 (2009).
142
See id.
137
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Because issuers can raise money more cheaply by going to
institutional investors by using private issuances, it likely creates an
uneven playing field where institutional investors have an advantage
over retail investors.143 Thus, it is no surprise that some expect retail
investors to become extinct in the near future, leaving a market
composed of just institutional investors.144 After all, why would an
issuer choose to spend more money to bring an issuance to the public
market when they could spend less and bring it to an institutional
investor?
Consequently, if individual investors wish to take advantage of
private placement investment opportunities and have the
discretionary income to risk, there is no compelling reason for the
government to bar them from participating in these types of
investment opportunities. This is particularly true in light of the fact
that investment risk and investment return are inherently linked
together.145 Usually, the higher risk investments have a correlating
higher potential for return on that investment.146
D.
Current Financial State
The current financial state of Americans is bleak; therefore, it
may make sense to offer retail investors better opportunities to
generate higher returns with their discretionary income.
U.S. savings rates have decreased over the past few
decades.147 In the 1970s, Americans were saving approximately 11
percent of their income.148 This average savings percentage began to
decrease in the 1980s, and by 2005 Americans were saving only 1
percent of their income.149 After the real estate bubble burst in 2008,
the trend reversed, with the annual savings percentage going up to 7
143
See id. (describing the advantages that mutual funds have over retail
investors because issuers can raise money more cheaply by avoiding the full
costs of securities registration when issuing securities to mutual funds).
144
See supra text accompanying notes 70–71.
145
Balancing Risk and Return to Meet Your Goals, supra note 5.
146
See id.
147
David Francis, How the Savings Rate Could Hobble the Economic
Recovery, U.S. NEWS, Jan. 6, 2012, http://money.usnews.com/
money/business-economy/articles/2012/01/06/how-the-savings-rate-couldhobble-the-economic-recovery (describing the current U.S. savings rate and
how it impairs the U.S.’s economic recovery).
148
Id.
149
Id.
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“ACCREDITED INVESTOR” STANDARD
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percent in late 2008 and 8 percent in the spring of 2009.150 It may
nonetheless be some years before the benefits of savings are realized.
As a consequence of the low savings rates, fewer and fewer
Americans are adequately prepared for retirement.151 Recently, some
investors experienced a dramatic decline in the value of their 401(k)s
that have in some cases depreciated by up to 75 percent.152 Moreover,
many individuals have had to resort to using their 401(k) savings to
pay bills they have accrued because of unemployment.153 This means
that many Americans have not been saving enough to retire
comfortably.154 And, some of those who did save money in their
401(k)s had risky investments and their savings were consumed by
the tumultuous stock market.155
To enjoy a comfortable retirement, an individual will likely
need to have saved a minimum of $1.1 million by the age of sixtyfive.156 Nevertheless, 54 percent of retirees have saved less than
$25,000 for their individual retirements.157 In addition to having
saved a mere fraction of the full cost of retirement, 42 percent of
150
Id.
Manny Krantz, Many Have Little to No Savings as Retirement Looms,
USA TODAY, Dec. 4, 2011, http://www.usatoday.com/money/perfi/
retirement/story/2011-12-02/retirement-not-saving-enough/51642848/1
(describing the gravity of the savings problem in the United States and
proposing solutions).
152
Id.
153
Id.
154
Id.
155
Id. As an aside, it seems as though based upon statistics and the lessons
gleaned from our most recent financial crisis, that if the country were to
regulate what kinds of investments some people can or cannot make,
regulators have a stronger argument for using age as a basis of regulation
rather than by using the accredited investor standard. Many of these nearretirees who have been most affected by the recent financial crisis are of an
age where the risk level in their portfolio may have worked to their
detriment. Coincidentally, the only age group that collectively meets the
accredited investor standards is the group containing members between the
ages of sixty-five and seventy-four. Therefore, as a group, individuals
between the ages of sixty-five and seventy-four have access to the riskiest
investment vehicles, but conventional wisdom says that as an investor
grows older, he or she should bear less and less risk. It may thus make more
sense to regulate investment activities on the basis of age than on the basis
of an arbitrary income or net-worth standard.
156
Id.
157
Id.
151
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retirees have debt, which further aggravates the problem.158 The
combination of retirees failing to save enough for retirement and
simultaneously possessing debt means that many Americans will
have to postpone their retirement.159 As a result, a growing number of
Americans are expecting to work into their seventies, and have no
plan in place to pay down their debts.160
Even worse, the recent decline in property values have added
to the financial problem that is still growing today,161 which may
explain why the SEC modified the definition of accredited investors
to exclude the value of residential homes.162 The home equity that
some homeowners were expecting to use for retirement is no longer
available to them because many homeowners suffered huge losses
when the value of their home declined precipitously between 2006
and 2011.163 Some economists predict that in 2012, American home
values will wane once again—falling by another 5 percent.164 For
many homeowners, these homes were their primary investments.
One of the reasons why property values may continue to
decline is because there are still excess vacant homes in the
marketplace.165 In fact, the predicted decline in home values does not
take into account that there are many houses undergoing the
foreclosure process, which have yet to enter the market.166 Some
predict that the housing market will not recover until these vacant
homes are off the market.167 Regardless, because home values have
declined to such a great extent over the past few years, there is less
home equity available for homeowners to use for retirement.
158
Id.
Id.
160
Id.
161
Id.
162
See supra note 20.
163
FIN. CRISIS INQUIRY COMM’N, FINANCIAL CRISIS INQUIRY REPORT 211
(2011), available at http://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPOFCIC.pdf.
164
David Leonhardt, Is Another Housing Crash Coming?, N.Y. TIMES BLOG
(May 11, 2011, 9:00 AM), http://economix.blogs.nytimes.com/tag/markzandi/.
165
Nin-Hai Tseng, Housing, Stocks, Gold and Oil: Hot or Not in 2012?,
CNN MONEY.COM, Dec. 28, 2011, http://money.cnn.com/galleries/2011/
fortune/1112/gallery.bull-versu-bear.fortune/3.html.
166
Id.
167
Id.
159
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“ACCREDITED INVESTOR” STANDARD
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Taken together, most Americans face a grim financial
outlook. With decreased savings combined with higher levels of debt
and declining home values, the average American faces financial
hardship for the foreseeable future. Given the current state of the
average American’s finances, it is only reasonable to create better
investment opportunities for Americans with discretionary income to
promote more efficient capital formation.
V.
Conclusion and Recommendation
The criteria for evaluating whether a particular investor can
afford to take risks should be based on whether the investor has
discretionary income, not on whether he or she is worth an arbitrary
amount of money, or makes some arbitrary amount of income. An
individual’s wealth is not necessarily indicative of his or her level of
financial sophistication, and yet wealthy individuals meeting the
accredited investor standard are allowed to make riskier investments
because it allows for better capital formation.
If an individual possesses the freedom to waste the entirety of
his or her discretionary income on completely inessential goods and
services or even give or gamble it away, why should the government
bar the same individual from using his or her discretionary income to
invest toward retirement, regardless of the level of risk? Affording an
individual with discretionary income the freedom to invest as he or
she chooses would benefit society because it would facilitate better
capital formation—which is precisely the reason why unsophisticated
wealthy individuals qualify as accredited investors.
Few investors qualify to invest in private placements as
accredited investors, yet it benefits issuers to issue securities as
private placements because, inter alia, it is cost effective and
confidential. Therefore, the investors who are eligible to invest in
private placements are able to take advantage of an exclusive
investment opportunity, which may be a reason why institutional
investors currently dominate the trading market.
Historically, institutional investors have grown rapidly and are
taking up an increasingly larger proportion of the trading market. If
institutional investors continue to saturate the trading market and
retail investors become an increasing minority, then eventually there
is a risk that the trading market may lose its retail investors. With a
smaller supply of potential investors, and a steady corporate demand
for capital, the cost of capital may rise, resulting in less effective
capital formation.
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Moreover, because issuers can save money in securities
registration costs by avoiding a public issuance, issuers are more
likely to want to attract investors in private issuances by offering
better terms. With most Americans suffering financially in the wake
of a countrywide financial crisis and a recent track record of
Americans inadequately preparing for retirement, it makes sense to
allow investors more freedom to invest their discretionary income in
whatever manner they choose.
The private placement exemption may primarily benefit those
who are already wealthy by affording them better investment
opportunities to the exclusion of retail investors in the U.S. A
potential problem is that because the private placement exemption
allows issuers a more cost-effective means of raising capital, issuers
may prefer to use private placements rather than dealing with the
regulatory rigmarole associated with pursuing costlier public
issuances.
Currently, there are no available studies tracking the
performance of institutional investors to determine whether there is a
statistically significant correlation between the variance in
investment returns as measured by Jensen’s Alpha168 and the growing
ratio of institutional investors to individual investors in the
marketplace. There is a pressing need for such studies that would
cover the time period spanning from 1980 to 2010 and track equity
investment returns in excess of the amount appropriate for the risks
undertaken as the ratio of institutional investors grew in proportion to
individual investors. Should future research reveal that there is a
statistically significant correlation between a decrease in the variance
of Jensen’s Alpha measures and the ratio of institutional investors in
the marketplace, this may suggest that it is more difficult for winning
institutional investors to generate abnormal returns when faced with
increasing competition from other institutional investors; in other
words, institutional investors may be able to generate better abnormal
returns when competing against individual investors, which could
imply that they have superior information or opportunities.
Alternatively, should future research find no statistically significant
168
Jensen’s Alpha is “the difference between a series’ realized or expected
rate of return and its expected position on the security market line given its
wirk level.” Jensen’s Alpha, EnCorr/Portfolio Strategist Knowledge Base,
MORNINGSTAR,
http://datalab.morningstar.com/knowledgebase/aspx/Article.aspx?ID=268
(last visited Apr. 5, 2012).
2011-2012
“ACCREDITED INVESTOR” STANDARD
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correlation, this could indicate that winning institutional investors are
able to generate similar abnormal returns against other institutional
investors as they were against individual investors, meaning that
individual investors perform similarly to many institutional investors.
Many of the restrictions that are currently placed on retail
investors are predicated on the anecdotal premise that individual
investors are unable to fend for themselves—but in the absence of
any empirical evidence in that regard. Future research ought to focus
on quantitatively measuring the performance of institutional
investors against other sophisticated investors to help determine
whether retail investors really do lack sophistication.